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Monday, March 15, 2010

Economists Confused On Cause Of Recession

If you ask economists what caused the recent recession you will likely get a wide range of different explanations that often reflect the economist's own world view. This disagreement makes it especially difficult to prevent the same scenario from happening again. See the following post from Economist's View for more on this.

Of course, we all know the proximate causes of an economic crisis: people are not spending, because their incomes have fallen, their jobs are insecure, or both. But ... where and why did it start? Why did it worsen? What will reverse it? It is to these questions that economists have been unable to offer clear answers.

The state of economic knowledge was just as bad in the Great Depression that followed the 1929 stock market crash. Economists did not predict that event, either. ...

Late in the Great Depression, in August 1938, an article ... in The Christian Science Monitor reported an informal set of interviews with US “professors, banking experts, union leaders, and representatives of business associations and political factions,” all of whom were given the same question: “What causes recessions?” The multiplicity of answers seemed bewildering, and did not inspire confidence that anyone knew what was causing the deepest crisis of capitalism.

The causes given were “distributed widely among government, labor, industry, international politics and policies.” They included misguided government interference with markets, high income and capital gains taxes, mistaken monetary policy, pressures towards high wages, monopoly, overstocked inventories, uncertainty caused by the reorganization plan for the Supreme Court, rearmament in Europe and fear of war, government encouragement of labor disputes, a savings glut because of population shrinkage, the passing of the frontier, and easy credit before the depression.

Although economic theory today is much improved, if we ask people about the cause of the current crisis, we will mostly get the same answers. We would certainly hear some new ones, too: unprecedented real-estate bubbles, a global savings glut, international trade imbalances, exotic financial contracts, sub-prime mortgages, unregulated over-the-counter markets, rating agencies’ errors, compromised real-estate appraisals, and complacency about counterparty risk.

More likely than not, many or most of these people would be mostly or partly right, for the economic crisis was caused by a confluence of many factors, the chance co-occurrence of a lot of bad things...

Consider the question of predicting events like the January 2010 earthquake in Haiti, which killed more than 200,000 people....[I]f one went beyond trying to predict the occurrence of earthquakes to predicting the extent of the damage, one could surely devise a long list of contributing factors – including even political, financial, and insurance factors – that resembles the list of factors that caused the global economic crisis.

Indeed, the crisis knows no end to the list of its causes ... in a complicated economic system that feeds back on itself in many ways...

Weather forecasters cannot forecast far into the future, either, but at least they have precise mathematical models ... derived from the theory of fluid dynamics and thermodynamics. Scientists appear to know the mechanism that generates weather, even if it is inherently difficult to extrapolate very far. ... The mathematical models that macroeconomists have may resemble weather models in some respects, but their structural integrity is not guaranteed by anything like a solid, immutable theory. ...

Unfortunately, in 800 years of financial history, there is only one example of a really massive worldwide contraction, namely the Great Depression of the 1930’s. So it is hard to know exactly what to expect in the current contraction...

This leaves us trying to use patterns from past, dissimilar crises to try to infer the likely prognosis for the current crisis. As a result, we simply do not know if the recovery will be solid or disappointing.

Amazing - a whole column and not a single mention of his book. But that may be because after arguing that we don't know the cause of the crisis, it's kind of hard to promote a book that explains what caused the crisis:

As George Akerlof and I argue in our recent book Animal Spirits, the current financial crisis was driven by speculative bubbles in the housing market, the stock market, and energy and other commodities markets. Bubbles are caused by feedback loops: rising speculative prices encourage optimism, which encourages more buying, and hence further speculative price increases – until the crash comes.

Part of the confusion is the failure to distinguish between the question of what caused the crisis and the factors that made it much worse once it occurred. But it is rather striking that if you ask a simple question, "what is the single most important factor in explaining why the crisis happened," there is very little consistency in the answers given by economists. I find it a bit disturbing that, even after this much time to figure it out, there is little consensus on what caused the problems. Worse, those that hate government seem to find government at fault, those that think that the deregulation movement that began in the 1970s was an error point to regulatory failures, and so on, and so on.

The fact that the evidence always seems to confirm ideological biases doesn't give much confidence. Even among the economists that I trust to be as fair as they can be -- who simply want the truth whatever it might be (which is most of them) -- there doesn't seem to be anything resembling convergence on this issue. In my most pessimistic moments, I wonder if we will ever make progress, particularly since there seems to be a tendency for the explanation given by those who are most powerful in the profession to stick just because they said it. So long as there is some supporting evidence for their positions, evidence pointing in other directions doesn't seem to matter.

The economics profession is in crisis, more so than the leaders in the profession seem to understand (since change might upset their powerful positions, positions that allow them to control the academic discourse by, say, promoting one area of research or class of models over another, they have little incentive to see this). If, as a profession, we can't come to an evidence based consensus on what caused the single most important economic event in recent memory, then what do we have to offer beyond useless "on the one, on the many other hands" explanations that allow people to pick and choose according to their ideological leanings? We need to do better.